Why is there a new lease standard?
In its review of SEC registrants, the Financial Accounting Standards Board (FASB) noted that publicly-held companies disclosed over $1 trillion of off-balance sheet leases. Per the current lease accounting rules, only those leases meeting the capital lease criteria are reported on the balance sheet, while many leases are structured to avoid these triggering criteria. Working to overcome this off-balance sheet risk and after nearly 10 years of working on a new lease accounting standard, the FASB issued ASU 2016-02 on February 25, 2016. ASU 2016-02, Leases, established Accounting Standards Codification (ASC) Topic 842, commonly referred to as the “new lease standard.”
The new lease standard defines “lease,” introduces new lease terminology and requires balance sheet recognition for most leases. The new standard will pose significant challenges to reporting entities. Chief among them is the impact these lease changes will have on compliance with debt covenants.
A lease requires both an identified asset and a right to control the identified asset over a period of time. Most leases should be straightforward, but lessors/vendors may attempt to revise agreements to keep liabilities off of the balance sheet. Thus, accounting for certain agreements will follow the new lease rules even if the word “lease” is not in the agreement’s title.
We currently have operating and capital leases. Under old generally accepted accounting principles (GAAP), operating leases are generally recorded solely on the income statement as lease or rent expense. If a lease meets the capital lease criteria, the leased asset is recorded as a fixed asset and the lease obligation is recorded as a liability. In each reporting period under old GAAP, the capital lease asset is depreciated and the capital lease liability is amortized and interest expense is recorded. New GAAP calls old capital leases “finance leases” but retains the terminology “operating leases.”
Balance sheet recognition.
New GAAP requires that ALL leases over 12 months in length be recognized on the balance sheet. For operating leases, this is quite a change. Both finance and operating leases will now be recognized as right-of-use assets on the balance sheet, offset by lease liabilities. Although the net effect on income and retained earnings is zero, debt service coverage ratios, for example, previously would not take into consideration any liability determined by the existence of operating leases. New GAAP will now increase the debt service expected to be covered by cash flow by the amount recorded as current maturities of operating lease obligations. Proactive communication with bankers and other financiers will be essential.
As of October 16, 2019, the FASB approved a proposal stating the effective date for the new lease standard for private companies and not-for-profits. The new lease standard is now effective for private companies and not-for-profits for annual reporting periods beginning after December 15, 2020 (2021 calendar year).
Please contact a member of your Corrigan Krause advisor team, or email firstname.lastname@example.org for further discussion.